Professional Documents
Culture Documents
EXAMINERS’ REPORT
September 2008
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
December 2008
Comments
Individual comments are shown after the solutions to each part question that follow.
© Faculty of Actuaries
© Institute of Actuaries
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
1
(i) The areas of discretion would be in respect of with profits business only.
Regular bonuses
The normal approach to setting regular bonuses. This includes smoothing of regular bonuses
from year to year and the frequency and timing of setting regular bonuses.
For any of the above if different approaches are used for different types or tranches of
business, this should be made clear.
Total payouts
How asset shares are used to determine final payouts would be described including the
method of calculation of asset shares.
The method of allowance for profits arising on the without profits business written in Fund B
would be included.
The document would also cover the desired relative proportions of regular and final bonus,
the allowance for enhancements to payouts from any inherited estate and the approach to
smoothing of final bonuses and/or payouts (for example, the maximum change in payout or
terminal bonus percentage).
Target ranges of unsmoothed asset shares and the practice regarding cross-subsidies between
different generations and groups of policyholders would be discussed.
The normal frequency and timing of setting final bonuses and the approach to setting final
bonuses in adverse circumstances would also be shown.
Situations in which a market value reduction could be used and how a market value reduction
would be determined would be described.
How surrender values are determined and changes that can be made to surrender value
calculations over time would also be covered
Other changes that can be made to early retirement terms would be described as would the
practice on switching between unitised with profits and unit-linked funds.
Page 2
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Investment strategy
A statement of overall investment strategy for the with profits fund would be included. Detail
would be given on the types of asset in which the assets backing with profits business can be
invested, limits on the relative proportions of each type and circumstances under which these
limits could be varied or breached.
The extent of asset / liability matching and the use of derivatives would also be described.
The document would also highlight counterparty exposure limits and any other overall
investment objectives.
General business risks accepted, for example strategic investments, would also be shown.
How any discretionary charges are set would be set out, e.g. charges for guarantees, options
or smoothing.
Apportionment of expenses between Fund A and Fund B would be discussed along with the
apportionment of expenses between product types within Fund B and the treatment of
exceptional or one-off expenses.
This section would set out purposes of the inherited estate, restrictions on its use, possible
actions if the inherited estate was higher or lower than certain amounts and the investment
strategy of the inherited estate.
Any amendments made to with profits management if the company was to close to new
business would be described. Current business plans regarding new business volumes and/or
possible closure would be set out along with how it might treat the with profits and without
profits (written in the with profits fund) new business separately.
Shareholder profit
The allocation of profit between shareholders and policyholders to the extent that this is
subject to some discretion. For example, where it is influenced by the valuation rate of
interest.
In addition how shareholder tax is reflected e.g. charged to the estate would also be
described.
Page 3
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Part (i) was generally well answered. Most candidates gave a wide range of topics covered in
the PPFM. Some however simply listed items in the PPFM rather than covering the areas of
discretion. Some also covered non profit business which was not required. Stronger
candidates scored well on this section.
(ii) Variable charges on unit-linked policies. For example, mortality risk charges or
expense charges.
Answers to part (ii) were mixed. Some candidates scored very highly giving a good
discussion of both discretion in premiums and charging and aspects of unit pricing
policy. Others offered very little for this part or simply repeated points made on
part (i).
(iii) Advantages
The purpose of the PPFM is to provide external parties with clear and comprehensive
information on the way in which the with profits policies are managed. This can
address the imbalance between the policyholder and company knowledge regarding
the product.
This could help to increase consumer confidence. This in turn can help to support new
business volumes and can help to reduce withdrawals from the with profits fund.
It can be used to demonstrate that customers are being treated fairly. This could
reduce the number of customer complaints, and the associated servicing burden. It can
also help to increase the regulator’s confidence in the company.
Drafting the contents of the PPFM can help companies identify areas where existing
practices might be unclear or inappropriate, and so can help them to rectify this.
Page 4
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
It also provides a formal framework for internal governance of with profits funds.
Disadvantages
Preparing the PPFM can be a significant and time-consuming task for both the
company and the regulator.
Three months’ notice must be given if the company wishes to change its Principles.
Changes in Practices must also be notified although this can be done retrospectively,
within 12 months of the change. All policyholders affected by the change must be
notified.
If the Principles of the PPFM have not been well drafted, then the company could find
that they are unable to implement quickly certain courses of action, for example in the
event of a fall in equity markets.
The company needs to balance its need to retain the ability to apply discretion with
the regulatory need for the PPFM to contain detailed information.
If the PPFM is too detailed then there is a danger that policyholders and/or sales
intermediaries could select against the company. For example, they could anticipate
changes to surrender benefits and switch funds in order to take advantage of this.
A “customer friendly” version must also be produced and maintained. The company
must draw attention to this policyholder version, for example in its annual statements,
or make it available on the website.
It is necessary to appoint an independent assessor to ensure that the fund has been run
in compliance with the PPFM. They will also produce an annual report for the with
profits policyholders.
The independent assessor role could be provided by a with profits committee of the
company, an independent person with appropriate skills, or a report from a non-
executive director (if very small volume of business). It may be advisable to introduce
a With Profit Actuary role alongside the introduction of the PPFM.
A number of candidates found part (iii) difficult. Most identified the basic purpose of
the PPFM to give clear information to customers but that introducing this would
introduce cost and effort. Many also described how this works in a UK context and
associated requirements such as independent reports. However, few candidates
adequately discussed the practical advantages and disadvantages of the additional
disclosure such as increased confidence and sales or any of the practical issues such
increased as visibility of strategy to competitors.
Page 5
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
(iv) It is necessary to obtain the Sanction of the High Court (or Court of Session in
Scotland).
The petition to the Court has to include a report on the scheme of transfer from an
independent expert.
Before it issues the sanction, the Court must be satisfied that the companies have
performed a number of tasks.
These are:
Any person, including employees of Company X and Y, can be heard in Court if they
feel that the transfer would adversely affect them.
The majority of candidates scored well on part (iv) correctly identifying the required
court process and much of the information and process requirements.
TCF
This structure makes it simpler to continue to manage each of the two sets of with
profits policyholders in the way they have been managed to date. In particular, the
way in which bonuses are declared.
Financial Strength
Option II avoids problems that arise if the two funds have different financial strengths
and any need to protect the closed funds policyholders entitlement to its estate
Page 6
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
We know that Company X has good financial strength. If Company Y has poor
financial strength, then the security of their with profits policyholders would be
increased post merger and those of the Company X with profits policyholders would
be reduced.
This would be less of an issue if the solvency levels were similar pre merger, i.e. if
both funds were considered to be sufficiently “strong” both before and after merger.
If the sub-funds were merged (Option I), it may be necessary to perform a one off
distribution of part of the estate of the stronger company immediately prior to the
merger.
Investment Strategy
Similarly, Option II avoids problems that arise if the two funds have different
investment strategies.
If the sub-funds were merged (Option I) then the equity backing ratio of one fund
would be likely to increase and the other to reduce.
Fund B is well capitalised, so it is possible that the equity backing ratio of Fund B
would fall post merger.
Miscellaneous Surpluses
If the sub-funds were merged (Option I), it would need to be decided whether ex-
Company Y with profits policies only benefited from profits/losses on ex-Company Y
without profits policies, and similarly for ex-Company X policies. This could be
complex to implement, but changing this could go against PRE. Option II avoids this
issue.
Also under Option II, new with profits and without profits business can continue to be
written into Fund B and will impact only ex-Company X policyholders. This is likely
to be in line with current practice and expectations for both Company X and Company
Y policyholders.
Under Option II the policyholders of Fund B remain isolated from experience in Fund
C. If Fund C became insolvent then, under the scheme of transfer, it would be the
shareholders of the new company that would have to support this, not the free estate
in Fund B. Under Option I, Fund B policyholders would become exposed to the risks
underlying the ex-Company Y with profits fund.
This could go against their reasonable expectations and they could also expect
compensation in such circumstances.
Page 7
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Practical considerations
If both funds are less than £500m in size, then keeping them separate could avoid the
need to report under the “twin peaks” regulatory environment.
There would be no need to rewrite the PPFMs (if these have been introduced by then).
Disadvantages of Option II
Closed fund
Company Y’s fund is closed to new business. If Option I was instead followed and it
was merged with Fund B, then it might be possible to maintain a higher equity
backing ratio going forwards rather than having to move into more secure assets as
the fund runs off.
Similarly expense economies may be greater under Option I, due to the delay of run-
off.
Both of these points could mean higher returns to ex-Company Y policyholders under
Option I and avoids the risk of shareholder support being required as in Option II
Practical considerations
Maintaining two with profits sub-funds under Option II will lead to some duplication
of effort:
• The company will need to maintain accounting and reporting systems that
separately identify the transactions arising in the two with profits sub-funds.
• The company will need to maintain separate asset portfolios.
• The company will have to produce a realistic balance sheet for both Fund B and
Fund C (if each is large enough to require this).
If the company continues to manage each set of with profits policyholders separately,
then there will also be additional effort in:
The total expense base of the company is therefore likely to be higher under Option II.
Policyholders might be unhappy or confused if they see higher bonuses given to other
policyholders in the same company with the same contract.
Page 8
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Investment Strategy
Keeping the asset pools segregated might mean that it is not possible to undertake
specific types of investment due to lack of scale, such as overseas equities or direct
property.
Most candidates covered the main points required by this question. Those that scored
well were candidates that gave supporting detail to explain their points by way of
practical examples.
(vi) (a)
(b)
Advantages
The same calculation program and process can be used for all with profits asset shares
for the combined company going forwards, which increases the efficiency. It could
therefore reduce company expenses once implemented.
It provides the opportunity to improve the quality of asset share calculations for one
or both sets of business, since it is likely that the more sophisticated approach will be
adopted.
Page 9
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Disadvantages
Changing the asset share methodology for either or both sets of with profits
policyholders could go against their reasonable expectations. It could not be applied
retrospectively.
The new merged company would have to ensure that it continues to treat customers
fairly. For example, it is unlikely that it would be able to implement a change that
would reduce the rate at which asset shares accrue going forwards (e.g. removal of
augmentation from free estate).
Changes that increase asset share accrual will reduce both reported (if “twin peaks”)
and actual solvency.
Part (vi) was generally well answered. Most candidates gave a number of details that may
vary in the calculation covering approaches to investment and expense allocation and a
number of possible deductions from asset shares. Fewer candidates scored well on the
second part. Many identified TCF may be an issue but few gave enough discussion to
demonstrate understanding of in what circumstances and to which policyholders.
Company X might have been writing term assurance business for much longer than
Company Y.
The greater the experience of an insurer in writing a particular class of business, the
more likely it is to be willing to retain more business in-house and the less it will want
to cede to a reinsurer (assuming that the business is written on profitable terms).
Reinsurers provide a greater level of assistance to those insurers that are ceding the
most business, hence this may have contributed to Company Y’s low retention.
Company X may have a much larger portfolio of term assurance business, in terms of
lives covered, than Company Y.
Page 10
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Risk appetite
For both companies, the profits/losses on term assurance business are largely borne by
the with profits policyholders. The two sets of with profits policyholders could have
different levels of risk appetite.
There may be a low risk appetite in Company Y, leading to the low retention limit
treaty being put in place. For example they could have expectations of very stable
bonus rates.
Marketing literature and the PPFM will have contributed to these expectations.
This low risk appetite is likely to have been a more important factor than Company Y
giving profits away to the reinsurer through ceding too much business.
External perception
It will want to avoid shocks to its results. However it will also want to avoid giving
away excess profits to reinsurers, which it should be retaining for its own
shareholders.
External parties are unlikely to view a company favourably if it passes most of its
insurance risk to a reinsurer. Sensible reinsurance arrangements where the
risk/reward trade-off have properly been considered will be well received by the
market.
Company Y might, in the past, have sold its business through channels producing
more variable term assurance claims, such as through direct marketing.
By contrast, Company X’s business might have been written alongside mortgage
applications for a large building society, in which case it would be expected that the
claims experience would be relatively light, with a fairly smooth distribution of the
likely size of claim.
Company Y might have a less well diversified portfolio for example Group business
or fewer product lines.
Page 11
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Other reinsurance
The reinsurance arrangements that both companies have in place for their term
assurance portfolios may be heavily influenced by the reinsurance arrangements that
each company has in place for other lines of business.
In the interests of simplicity and streamlining administration, the companies may have
decided to have treaties such that the retention limit is the same for all types of
without profits business. This may result in the companies each over/under-insuring
for particular lines of business if they were each considered in isolation on their own
merits.
Company X might have other reinsurance treaties in place, such as excess of loss, stop
loss and/or catastrophe treaties.
Company Y might have been able to obtain much cheaper reinsurance rates.
Financial strength
Company X has good financial strength, meaning that it is able to withstand some
degree of variation in claims experience. If Company Y is weaker, this could be a
factor leading to its lower retention limit.
Company Y might require financing reinsurance in order to support capital strain, and
the reinsurer might require a lower retention in order to provide this.
Other factors
Company X might have been more proactive in regularly reviewing its reinsurance
arrangements than Company Y. Company X might have had a similar treaty to
Company Y many years ago, but over time may have gradually increased its
retention.
Company Y might have closer relationships with the reinsurance company or might
have more awareness of the financial benefits of reinsurance.
(viii) Exclusions
The Director is correct that catastrophe reinsurance treaties generally do have a large
number of exclusions.
Page 12
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
This has become even more the case since 11 September 2001. Risks such as
terrorism, war, riot and so on are regularly excluded from the cover offered under
mainstream catastrophe treaties. In addition market capacity has reduced and
premiums have increased
In deciding whether the catastrophe cover is necessary, the Board will have to
consider the types of business that the company writes.
It will also consider the extent to which it is exposed to aggregations of risk in the
event of a catastrophe. For example it will consider the distribution of sums assured
covered and the profile of its policyholders, e.g. whether they all reside in one
particular geographic area.
This should particularly be considered for group business where the aggregation of
risk is more obvious, e.g. the life insurance company may cover all of the employees
of a particular firm where multiple claims could arise in the event of, say, a building
collapse. The company may wish to model extreme events to assess their impact.
Financial protection
Company X may wish to have steady, reliable profit results from period to period,
particularly if it is listed. Hence it is important that adequate reinsurance cover is in
place for extreme events, due to the impact that these could have on the financial
results and in turn the share price of the company.
Cost
Not renewing the treaty will save the company some money.
Page 13
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
However catastrophe treaties are designed to cover only very rare events, so the price
of cover is generally fairly low. It is therefore likely to be worth putting it in place to
provide adequate financial protection at relatively low cost.
Conclusion
A number of candidates struggled on part (viii). Many identified that ICA reserves may be
impacted without the cover and that solvency may be threatened by an extreme event but few
discussed the nature of the company and that the extent to which it faced aggregations of risk
may impact its decision.
• Allow the impact of key business strategy decisions to be assessed, for example
bonus strategy or investment strategy
• Show the amount of new business and new business strain that can be supported
by the available capital.
• Estimate the pattern of capital releases to shareholders.
• Help to assess the cost of capital in calculating the embedded value of the
company.
• Enable risk measurement and management within the company.
In addition, for closed or declining with profits funds, projections are useful in
preparing run-off plans for the fund.
Most candidates scored well on part (i) giving a range of relevant examples.
(ii) Issues
The regulatory solvency position is strong, but it is weakening over the next few
years, before starting to improve again at the end of the plan period.
Some of the excess assets in the Long Term Fund are required to finance future new
business.
It can be seen that New Business Strain over the early plan years is more than surplus
emerging on in-force business.
One of the reasons why solvency appears to be strong is the use of negative non-unit
reserves.
These are not tangible, so cannot be transferred to support dividends.
The only excess assets available for transfer must be cash, fixed interest or unit-linked
assets.
Page 14
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
Selling off unit-linked assets would go against FSA principles and would in any case
result in mismatching.
The fixed interest bonds appear to be being used to match conventional business.
Hence selling off these assets to transfer to shareholders would result in mismatching,
hence increasing reserves.
Cash and deposits are required to pay for actual cash outflows from new business
strain and other expenses in the early years of the plan.
In summary whilst the regulatory position is strong there are limited distributable
assets available to transfer to shareholders.
It should also be noted that net non-linked liabilities (immediate annuities plus non-
unit reserves) are likely to go negative after the end of the plan period, if new business
continues, hence the company may not be able to take full advantage of negative non-
unit reserves in future.
Any transfer would reduce the resilience of the long term fund to adverse experience,
such as falling stock markets reducing unit linked management charges, improving
annuitant longevity, increasing or exceptional expenses, to enable future new business
to be written. A strong company may also help support the company’s share price or
credit rating.
The company should also consider the need to be solvent on a Pillar 2 as well as a
Pillar 1 basis. It is possible that Pillar 2 is more onerous due to persistency and
annuitant mortality risks.
It could also be noted that distributable assets in the Shareholder Fund (i.e. excluding
the head office property) are running down quickly, and the current dividend policy
will not be supportable after a few years beyond the end of this projection period.
Most candidates struggled with part (ii), which was a challenging question. Many
identified the trend in solvency and gave some examples of why retaining some
surplus capital was advisable, e.g. to cover mortality improvements. Only the
strongest candidates were also able to identify that most of the assets of the fund were
either required for matching or could not be used to support a dividend payment and
consequently missed many of the available marks.
To improve its ability to pay bonuses longer term the company must generate more
profits.
It may achieve this through increases the profits it makes on writing new business.
This may be through increasing the volume it sells or the profitability of sales.
Page 15
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
It can also increase its profitability through improving its experience on its existing
business. For example it may be able to cut its cost base
The company could consider weakening the valuation basis for the immediate annuity
business.
However the size of portfolio is unlikely to provide much in way of surplus.
The change cannot be seen as arbitrary.
It also needs to comply with appropriate guidance and regulations.
The company could consider changing the valuation basis for unit-linked business.
It could look at using actuarial funding, thus reducing new business strain.
However, this would mean that the company would not be able to use negative non-
unit reserves.
Whether actuarial funding would be feasible would depend on the nature of the
policies.
The company could instead review the basis underlying the non-unit reserves,
although it would also need to consider constraints on their use.
To alleviate the issue that negative non-unit reserves are unlikely to be fully
recognisable beyond the end of the plan period, the company could:
However, it should be noted that continued recognition of non-unit reserves does not
alleviate asset transfer and mismatching issues.
The company could consider securitisation of a block of in-force business.
This would effectively mortgage the in-force surpluses and provide actual assets up
front with which long term transfers could be financed.
The company may sell its Head Office building and lease it back. This would generate
the value of the property upfront.
Page 16
Subject SA2 (Life Insurance Specialist Applications) — September 2008 — Examiners’ Report
It may have other inadmissible assets it can sell and reinvest proceeds in admissible
assets to increase solvency.
It may also reconsider its investment strategy in the Shareholder fund. It may invest
more aggressively to increase returns but would need to be mindful of the increased
volatility.
It may reduce its new business volumes to reduce new business strain but would need
to consider the impact on longer term profits.
It could also increase or front load its charges on unit linked products but would need
to consider the impact on marketability.
Most candidates found part (iii) difficult to score well on. Many mentioned a number
of financial engineering options such as securitisation but missed marks by not giving
an explanation as to how or why they impacted solvency. In addition many candidates
restricted their answer to short term financing activities and failed to score many
marks for actions that would increase longer term profitability and as such increase
dividend paying capability.
Page 17